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3 Things: The Fed Is Screwed

Submitted by Lance Roberts via STA Wealth Management,

The LMCI Index Says The Fed Is Late Again

In May of 2014, the Federal Reserve began discussing a newly designed labor market index to help support their claim that employment conditions in the U.S were improving. This was an important facility for the Fed which needed support to raise interest rates. My good friend Doug Short has a complete discussion on the LMCI, which is worth reading for context. As he defines:

"The Labor Market Conditions Index (LMCI) is a relatively recent indicator developed by Federal Reserve economists to assess changes in the labor market conditions. It is a dynamic factor model of labor market indicators, essentially a diffusion index subject to extensive revisions based on nineteen underlying indicators in nine broad categories.

 

The indicator, designed to illustrate expansion and contraction of labor market conditions, was initially announced in May 2014, but the data series was constructed back to August 1976."

Unfortunately for the Federal Reserve, the index has not supported the Fed's claims that employment is growing at a rate strong enough to withstand a tightening of monetary policy. In fact, as shown in the chart below, the LMCI index (smoothed with a 12-month average) has been a leading indicator of future weakness in employment. The recent downturn in the LMCI suggests that employment gains may more muted in the months ahead.

Therein lies the problem for the Fed. If the LMCI is indeed forecasting weaker employment, then the Fed's ability to raise interest rates is negated. However, as shown in the chart below, the Fed has ALWAYS been late to the game when hiking interest rates. Each time the Fed began hiking interest rates was at the point the LMCI had effectively peaked. 

The Fed is once again very late to the game in hiking rates. The problem is that with the economy growing at less than 2% annualized, there is very little wiggle room for a policy mistake.

Retail Sales Decline

While the weakness in the LMCI is suggesting more disappointing employment growth ahead, retail sales are suggesting that the economy is likely much weaker than headlines suggest. 

Given all the massaging of data through seasonal adjustments, the chart below using the NON-seasonally adjusted data smoothed with a simple 12-month average. This gives a much more realistic look at what is actually happening with retail sales in the economy that makes up roughly 40% of total personal consumption expenditures. I have also provided the SA adjusted data to show the correlation between the two series. 

As shown, when retail sales have fallen below 4% growth it has historically been a leading indication of the onset of a recession. While there has been no official recession call as of yet by the NBER, it is important to remember that much of the economic data is subject to rather large annual revisions. It will not be surprising to see economic growth revised lower next year. 

The chart below shows the annual rate of change in "control purchases" which is more closely related to the actual activity of average consumers. I have overlaid the analysis with a simplistic economic cycle. Again, as shown above, control purchases are also suggesting that the economic environment is, in fact, very weak. 

The weakness in retail sales will feed into the personal consumption component of GDP which comprises almost 70% of the economic equation. This will be a problem for the Fed. 

What Inflation? PPI Declines Again

Of course, let me once more remind you why the Fed raises interest rates - to SLOW economic growth and QUELL inflationary pressures in a potentially OVERHEATING economic environment. 

With Q3 economic growth rates closer to 1% than 2%, there is little danger of an overheating economy currently. Furthermore, as shown in the composite inflation index below (average of both PPI and CPI), there is absolutely no worry about spiking inflationary pressures.

Of course, this is why the Social Security Administration just announced there will be NO INCREASE to social security payments this year. Unfortunately, for those recipients there will be no offset for sharply rising healthcare costs, property taxes or insurance payments. 

For investors, the deflationary decline will erode corporate profitability and ultimately stock prices. As shown in the chart below, sharp declines in inflation have generally been associated with negative annual rates of growth in the financial markets. 

Weakness in the financial markets ultimately weighs on consumer confidence which is why the Federal Reserve has been focused on supporting higher asset prices. A collapse in stock prices will quickly turn in to a negative feedback loop for the economy.

The Federal Reserve is quickly becoming trapped by its own "data-dependent" analysis. Despite ongoing commentary of improving labor markets and economic growth, their own indicators are suggesting something very different. 

As I have stated previously, while the Federal Reserve may hike interest rates simply to "save face," there is indeed little real support for them doing so. Tightening monetary policy further will simply accelerate the time frame to the onset of the next recession. Of course, the Fed knows this which is why they recently floated the idea of "negative interest rates" out into the markets. In other words, they already likely realize they are screwed

Just something to think about.